China and Raising Reserve Requirements May Result in Slow Demand for Iron Ore

Is that a deep sense of foreboding you feel as well, dear reader? It could be we just have a bad case of the Mondays. But today’s Markets and Money will try to do the impossible: look just over the economic and geopolitical horizon. We’ll tell you what we see and what investors should do about it.

First though, why panic? Stocks finished up for the week for the first time in a month last week. And it’s earnings season. On the S&P 500, 377 companies have reported earnings from the December quarter. Of them, 277 beat analyst estimates while 67 missed.

Here in Australia it’s a huge week for earnings. BlueScope Steel reports today. Tomorrow, you have Foster’s. On Wednesday, Coca-Cola Amatil and CSL. Thursday is a biggie with Lihir, Qantas, Santos, and Wesfarmers. And Friday, Andrew Forrest and Fortescue Metals Group tell us how the iron ore business is.

Come to think of it, the iron ore business is a good case study for today’s conversation. Earnings are backward looking. What we all want to know is how business is going to be this year and whether stocks are already priced for any of that future earnings growth. So what’s the story?

The rumours making the rounds are that Chinese steel mills – rather bitterly – have accepted a 40% increase on last year’s contract iron ore price average of $60. Even at $84, though, the contract price would be well below the current spot price. That’s closer to $130.

Fortescue is Australia’s third-largest ore producer. Naturally, higher contract prices and an elevated spot price would be good news for it and all the other aspiring ore producers in the West. This is why Diggers and Drillers editor Alex Cowie is set to recommend two new would-be ore producers (hopefully after the market closes today).

His number one recommendation does well as long as contract prices are above $41. The company has a cash cost of production of $31 per tonne, plus another $10 to amortise the capacity expenditures (although these depend on the final figures to be released in an upcoming Bankable Feasibility Study).

All that makes sense to us, and is an excellent punt on higher ore prices. But as a contrarian, we also wonder if ore prices are peaking out now just as they did in 2007. We hope we’re wrong. But two news items published over the weekend gave us the heeby jeebies. Both could be increasingly bearish for resource stocks.

The first is that China’s banking authorities increased reserve ratios at banks to 16.5%. It was a 50 basis point rise. According to Colleen Ryan at the AFR, it removes US$300 billion from the Chinese economy. But it scared world markets even more.

If China keeps raising reserve requirements to contain inflation, it could slow demand for credit by real estate speculators. That would slow commercial real estate and fixed asset investments. And that would slow demand for Australian iron ore (among other things).

If you read today’s papers you’ll see Chinese officials are worried about inflation (January producer prices were up 4.3% over December prices). But the International Monetary Fund (a policy tool of the Western Welfare states) is pushing for higher inflation targets. A new IMF paper says that cash hand outs to manage higher unemployment should be a standard part of monetary policy. But as these push up inflation, governments will have to tolerate just a bit more inflation than current targets allows. We’ll get back to this fraud in a moment.

With China, the authorities are quite rightly worried about inflation. And the biggest sign of inflation is the commercial property market where a massive bust is brewing. According to Jack Rodman – who makes his living selling bad real estate loans – there are 55 empty office buildings in Beijing with another 12 on the way.

Figures suggest that the vacancy rate in Beijing real estate is 22.4%–meaning nearly one of every four office buildings is empty. In the CBD, it’s an even higher 35%. And this year, another 1.2 million square metres of new space will be added to the 9.2 million square meters that already exist.

Now you know where all that iron ore is going. And now you know why Australia’s resource earnings could be in jeopardy if the Chinese real estate bubble pops. Of course you might argue it’s not a bubble. It’s just the rest of the world wanting to hang out its corporate shingle in what will be the biggest economy in the world over the next 100 years.

Maybe. But in January alone, Chinese banks loaned $203 billion dollars. That was more than the previous three months combined and 20% of the annual target. The government will try and slow down the lending boom over the Chinese New Year. But we’d be very worried that the Chinese lending boom has already driven up some commodities two and three times from their 2008 lows – and that a severe correction could be on its way (soon).

And here you thought Greece defaulting on its sovereign debt was the big story. Granted, that IS a big story. Harvard University Professor Martin Feldstein says the current crisis exposes the major flaw in the Euro’s design. “In Europe, they have a single monetary policy and yet every country can set its own fiscal and tax policy.”

Now, you have the Germans telling the Greeks to suck it up and live within their means. We’ll see how that goes. Remember, the last two World Wars started in Europe. These people know how to violently disagree. Not even 50 years of feel-good trans-national progressive thought can quench the natural differences of language and culture.

But what you see from the IMF’s move toward higher inflation targets and from the higher debt-to-GDP ratios across the globe (or more state intervention in the economy a la China) is what we think is a high water mark in the hubris of the “multi-national nation state.” These are large, artificial political and economic unions that are torn in different directions by the economic imperatives of globalisation (outsourcing, lower wages, cross-border integration) and the political realities of globalisation (lower wages at a time of ageing populations that demand more services and money from the State).

Granted, the Greek crisis may not infect the globe the way the subprime crisis did. Larry Kantor of Barclay’s says most of the $200 billion in at-risk sovereign debt from Greece, Spain, and Portugal is held by Europeans. Thanks to AIG and Goldman Sachs, Wall Street managed to distribute $1.5 trillion of its high-risk, high-yield subprime backed crack across the globe (what Alan Greenspan has called the dis-aggregation of risk…which roughly translates…eat that suckers!)

But will Greece take the Euro with it? And are Europe’s currency and debt problems the leading edge of the larger problem with Japan, the U.S. and Europe: they have lost economic competitiveness to the developing world (Brazil, China, and Russia) but insist on a social living standard that you can only afford if you have a productive economy generating surplus wealth.

Keynesians mistake growth with wealth. More government money taken out of the private sector and given away as stimulus promotes a kind of growth. But it is activity without the purpose of profit. Socialists will tell you that’s that good. We’d argue it’s a misallocation of resources (land, labour, capital, and commodities).

The trouble is that in reaction to the high-profile of leveraged finance, governments are increasing their take of private wealth. In the U.K., for example, the cash-strapped government wants a 3.5% hike in the value added tax to a European standard 20%. This will presumably keep the government solvent for a little while, spreading the wealth around as long as people bother trying to generate it.

But increasing taxes without reducing spending does nothing to increase productivity or prosperity. It just takes money out of productive hands and puts into the hands of preferred political constituencies. Yet when you produce nothing of value in the market place, you have to scour for revenues wherever you can.

Here in Australia, the Business Council of Australia has called for lower government spending. But you might have missed the fact that it also called for the retirement age to be raised to 73 by 2049. The Council says that by 2049, the number of Australians 65 or older will grow from 2.9 million today to 7.4 million.

The best way to deal with that – from the government’s perspective – is to raise the retirement age so you can’t begin drawing your old age pension till later-preferably not before you die. This keeps you paying into the system longer without drawing any benefits. That should keep it sound, for awhile.

Or not. By our reckoning, you’ll see more and more people choosing to retire now. That is, you’ll see people chose to liquidate their financial assets and convert into more tangible wealth beyond the reach of the tax man (when it’s possible and legal). And you’ll see the collapse of the most artificial creature of the last 200 years, the multi-national nation state. More on that tomorrow.

Dan Denning
for Markets and Money

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.

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10 Comments on "China and Raising Reserve Requirements May Result in Slow Demand for Iron Ore"

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Larry Kantor of Barclay’s … according to the NYT you could have a credibility problem Official exposure of the US banks (dominated by top 10 lending) to the PIIGS was said by Reuters on Feb 9 to be $176 billion ….. but like the NYT says what powers those taking the counterparty risk positions on the PIIGS? USD leverage outside the score card or off balance sheet of the $176b if you will. You don’t find German or French investors taking on sovereign risk anymore, and with a carry swap play layered over it and a zero rated USD… Read more »

The dude from PIMCO said the nations can either grow their way out of debt, or inflate their way out. But since the oil production has peaked out, there is no more growth to be had,…and if the consumers wont borrow… how can they generate inflation?? It should be intereting to watch, a bit like a slow motion freeway pileup. The down side is that we are all passengers.

Da n

Nice article Ross. GS is involved in Greece’s demise, hmm. Kind of like Midas’ curse, except everything turns to crap when they touch it.


Oooh, aaah…
China is designing the noose.
I hate to say I told you.
Let the games begin.

Ned S

Yep, Pauline’s a step ahead of the game as always and reckons Oz iz no good no more too – So it’s orf to the ole Land of Hope and Glory for her … :)


Liked your article Ross…you imply then that US origin derivative deals are prevalent around the globe waiting to cause trouble back home?

Ned its interesting old Pauline has a few quibbles about OZ but how then does she justify moving to UK.

Dan/Lachlan, the Goldman story I like best is that surrounding the case of Yellow Freight, a US LTL trucking carrier, now known as YRC Worldwide (YRCW). Now YRCW are based down in the land of Dorothy (Kansas City or Overland Park if you get picky about it as they do locally). YRCW has never been any good at making money, but neither has the whole US LTL sector, you could ask Peter Abeles about it with his TNT Best-0-Bell and TNT New Holland messes but of course he is as dead as Ansett and AWAS … but I digress, except… Read more »
Sorry, I forgot the point that had me starting to think back to YRCW. That is the “collateralising their obligations” part of this report. And I am asking myself why the US State Dept might be complicit in a financial exercise that would be MAD? There is no doubt in my mind that US Inc is behind those hedgies taking on the flotsam jetsom of the EU even if Stiglitz is rolled out playing the convenient fool, but we are talking about Bear Stearn events with dire consequence in the US.. But beyond private profit a la YRCW I… Read more »

Wow Ross. Tyler prints a mean article. Maybe this Greek thing is going to be another major stumble. Cant wait to see how commodities/markets trade through this week.

What I want to know is this. This new letter and its sister publication the DR always makes the point that the just around the corner is the end of financial world as we know it. The Western world and now China are going to implode and lead us all back to living our lives like we did in the 15th century. Now if that is the case then fair enough and i agree with what you are saying about the real estate lie that is currently in place. What i cant understand though is in your free news letters… Read more »
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